As investors increasingly look to ETFs as a foundation for their investment portfolios, we answer 7 key questions to consider when investing in ETFs.
An ETF (exchange traded fund) is a pooled investment vehicle with shares that can be bought or sold throughout the day on a stock exchange at the prevailing market price.
There are many types of ETFs, including those that invest in: indexes, market sector indexes, active strategies, smart beta strategies, themes, factors, physical assets (like real estate and infrastructure), among many others.
ETFs issue shares that can be traded on the stock exchanges where they are listed—each share of an ETF represents an interest in the underlying assets of the fund. Most ETFs are regulated; this provides investor protections, such as oversight by an independent board of directors, and the requirement that fund assets be held separately from the assets of the adviser, among many others.
ETFs cover every asset class and almost every global market. With ETFs, investors can also access almost any investment strategy, such as:
However, the majority of ETFs are index-based, that is, they are designed to track the performance of a designated index.
ETFs follow a wide range of investment strategies and objectives. Understanding the basics is critical, such as: What the ETF seeks to achieve, against what benchmark, and how this will be achieved, what assets it will buy to achieve this, and what risks the ETF takes to generate performance.
What Does the ETF Seek to Achieve?
Index-Based ETFs: Index-based ETFs typically seek to track the performance of an index. How these indexes are constructed matters to the performance of the ETFs tracking them. For example, an index might weight its holdings equally; by market capitalization; by dividends; or through many other mechanisms.
Actively Managed ETFs: Actively managed ETFs seek to outperform a particular benchmark or index by making active decisions to accept and reject securities and assets, rather than invest in the overall market.
What Assets Does the ETF Buy to Achieve its Objectives?
You should also assess how the ETF seeks to achieve its investment strategy. For both index and active approaches, what assets will it buy to replicate the index performance (index), or outperform the index performance (active).
An ETF may invest in the underlying securities in the index it tracks, known as physically-backed ETFs. Alternatively, it may invest in a representative sample of securities in the index. Some ETFs may also employ derivative instruments to track an index, rather than the underlying securities or assets. The chosen approach may affect how well the ETF tracks the index (tracking difference), and its overall risks.
What Risks Are Associated with the ETF?
Like all investments, ETFs are subject to risk. The principal risks are typically those associated with the ETF’s investment objective, and the assets it acquires to meet these objectives. Risks can also include currency, interest rates, the impact of economic growth, and other factors that impact the market, and the assets.
One risk of index-based strategies is tracking error (the difference between the return of the ETF and the return of the index it tracks) —more on this in Question 6.
Another risk for all ETFs is premium/discount volatility (that is, disparity between the market price of ETF shares, and the market value of the underlying assets — net asset value or NAV). Disparity can occur because shares are traded on the exchange, and temporary sentiment and market volatility can drive prices beyond NAV. However, with most ETFs the price should usually correct again towards NAV over time. The longer the investment term generally, the less relevant these types of movements are for the investor.
Investors use ETFs in a wide variety of ways, such as:
Management fees are the cost the asset manager charges for managing the ETF, typically a percentage fee per annum, charged monthly.
Fund Operating Expenses
Like mutual funds, there are additional expenses to the management fee with ETFs such as advisery services, administration, and recordkeeping, among other things. These fees are also commonly called an “expense ratio” and are expressed as a percentage of fund assets and paid annually.
Because ETFs are exchange-traded, investors must buy and sell ETFs through a broker, who typically charges a commission for this service.
When buying or selling ETF shares on the secondary market, there is typically a difference between the highest price a buyer is willing to pay for an ETF share (the “bid”), and the lowest price a seller will accept to sell an ETF share (the “ask”). Bid/ask spreads are typically lower for larger ETFs and those that are heavily traded and/or highly liquid.
The Costs of Frequent Trading
While it is easy to understand costs for buying and holding an ETF for the long term, when investors trade ETFs more regularly, they incur additional costs—trading costs. Trading costs are not actual costs and expenses in the design of ETFs, but rather, the impact from outside costs on the returns an investor achieves.
The types of costs outside of the ETF that can reduce returns include:
While past performance is not an indication of how an ETF may perform in the future, an investor may wish to evaluate an ETF’s performance against its stated objective or benchmark.
For an index-based ETF, performance is measured against its benchmark by the ETF’s tracking difference (which shows how closely it has been able to replicate the benchmark).
For an actively managed ETF, an investor might look at how the ETF has performed, based on the outperformance objective and the benchmark.
Tracking Difference or Error
Tracking difference (sometimes call tracking error) is the extent to which the ETF’s return deviates from the return of its benchmark index. Tracking difference can be influenced by a number of factors, such as how an ETF seeks to track the index (that is, whether it invests in every security in the index or in a representative sample of securities in the index), the ETF’s operating expenses, and how the manager handles index rebalancing and corporate actions.
Tracking difference is the actual difference between the performance of the ETF and its benchmark. Tracking error is this difference expressed in standard deviations.
Most investors buy and sell ETFs on the stock market at a market-determined price, typically trading through a brokerage account, just like trading a stock.
As with buying and selling shares, there are two basic options when trading ETF shares: market orders and limit orders.
A market order is an order to buy or sell a security at the best available price, at the price that has been created on the market by the supply and demand. Generally, this type of order will be executed immediately. Although placing a market order usually ensures that a trade will be executed, the price at which the order will be executed is not guaranteed to be an optimal price. It is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed.
A limit order is an order to buy or sell a security at a specific limit price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute. A limit order can only be filled if the security’s market price reaches the limit price, with the right amount of stock demand to meet your trade. While limit orders do not guarantee execution, they allow the investor to control the price at which they are willing to buy or sell.
Liquidity refers to how easily shares can be bought or sold without moving the market for those shares. Securities with high trading volumes are generally considered more liquid.
ETF liquidity should be considered with respect to both the ETF shares and the underlying securities the ETF holds. Highly liquid ETFs and ETFs that have highly liquid underlying securities (even if the ETF shares do not have high trading volumes) typically have narrower bid/ask spreads than ETFs that trade less or hold less liquid securities.
*Source: Morningstar as of period end December 31, 2018.